Recent equity market gains have been driven by a narrow group of stocks and momentum-related factors, creating hidden concentration risk in many portfolios. In this article, portfolio manager Matt Jones argues that true diversification comes from accessing different return drivers and differentiated research.
For much of the past few years, equity investors have been rewarded for owning what has already been working.
Markets have become increasingly concentrated – a relatively small number of stocks have driven a significant share of index returns, while factors such as momentum have become powerful forces in portfolio performance.
In many cases, simply being exposed to markets has meant becoming increasingly exposed to these same drivers. Moreover, when something works for a long time, it can start to feel less like a risk and more like a certainty.
That is where I think investors should be asking some important questions. Not necessarily about what has worked, but why it has worked. And, perhaps more importantly, what is actually driving portfolio returns beneath the surface?
Hidden concentration risk in portfolios
When we talk about concentration, most people immediately think about stock or sector weights, but concentration can exist at a much deeper level.
You could have several managers, multiple strategies, different mandates and yet still end up heavily exposed to the same underlying factor. Momentum is a good example.
I have always thought momentum is like a wolf in sheep’s clothing. Quality investing isn’t momentum. Growth investing isn’t momentum. Even index investing isn’t momentum by design.
But when enough capital crowds into the same ideas for long enough, many roads eventually lead to the same destination and the distinction between quality, growth and momentum begins to blur. In my mind, that is worth paying attention to.
Success can create its own risks
One of the interesting characteristics of momentum is that it tends to reinforce itself. Strong performance attracts flows, pushing prices higher. Higher prices then attract even more capital. And so the cycle continues. Until it doesn’t.
The challenge is that momentum often looks safest right before it becomes most vulnerable. None of this means momentum is inherently bad. Far from it; momentum has been one of the strongest drivers of equity market returns in recent years. But as investors, it is worth considering whether portfolios are benefiting from deliberate exposure to momentum, or whether exposure has simply accumulated over time as a by-product of portfolio construction.
There is an important difference between consciously making a factor allocation and discovering one only after conditions change.
Looking beyond the obvious
One of the lessons markets repeatedly teach us is that diversification is rarely about owning more things. It is about owning different return drivers.
That is becoming increasingly relevant in a world where data is widely available, and as many investment approaches draw insights from similar information sets.
If everybody has access to the same data, the same screens and, increasingly, the same AI tools, where does genuine differentiation come from? That is a question we are spending a lot of time thinking about across the industry.
In my experience, some of the most persistent sources of alpha come from areas that are harder to replicate.
Fundamental insights, deep company research and forward-looking views remain valuable because they involve judgement, context and interpretation, not simply historical datasets. The future rarely looks exactly like the past.
A portfolio construction conversation
For investors, I do not think the key question today should be whether momentum will continue to work. A more useful question is what will happen if market leadership changes.
In that scenario, investors will need to know the answers and implications of a series of portfolio construction questions.
How much of a portfolio’s return profile is dependent on a narrow group of dominant stocks, sectors or factors? How diversified are the underlying alpha sources? What risks are investors actually being paid for taking?
These are not necessarily warning signs that allocations are wrong, but they are healthy portfolio construction questions to know the answers to.
Some investors may conclude that their existing exposures remain appropriate, while others may identify areas where diversification could be improved. Either outcome is valuable.
Back to investment basics
Markets will always rotate, and leadership will always change. What matters is understanding what is driving outcomes before those changes occur. In recent years, there has been a tendency to focus on what has worked, whether it be momentum, growth, AI-related themes or benchmark leadership.
But from a portfolio construction perspective, the more important question is often where the next source of alpha is likely to come from. That is why differentiated research remains so valuable.
At Fidelity, we have spent over half a century building a global fundamental research platform – not to predict the latest market trend, but to help identify opportunities and risks before they become obvious to the broader market.
What makes fundamental insight powerful is that it is inherently forward-looking. It combines data, experience, company engagement and judgement in a way that backward-looking models cannot.
Interestingly, our own research has shown that analyst insights have historically exhibited low correlation to traditional factors such as momentum, value, growth and quality.
That is important, because it highlights a broader investment principle: genuine diversification comes not only from owning different securities, but from accessing different sources of information, perspectives and return drivers.
The other part of the equation is portfolio construction. Great insights can come in many forms but understanding how those insights interact within a portfolio is equally important.
In today’s market, where factor exposures can build quickly and often unintentionally, a disciplined approach to portfolio construction can help ensure returns are driven by investment insights rather than hidden concentrations.
For investors navigating an increasingly concentrated market, that may be one of the most important conversations today.
Not whether momentum will continue to work, but whether portfolios are sufficiently diversified should market leadership change.
Momentum can be a powerful tailwind when it is working; the challenge is ensuring that it is not the only engine powering the portfolio.
Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. The writer’s views are their own and do not constitute financial advice.
This information should not be relied upon by retail clients or investment professionals. Reference to any particular investment does not constitute a recommendation to buy or sell the investment.
Main image: diversification, investment, equities, jakub-zerdzicki-ynllMMWBdi0-unsplash
